CFA 1 Economics-III

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Economics - III
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2

Reading 20: International Trade and Capital Flows
Reading 21: Currency Exchange Rates
Expect around 4-5 questions in the exam from todays lecture
Mapping to Curriculum
Key Concepts
Explain Motivation For And Advantage Of Trading Blocs,
Common Market, And Economic Unions
Balance of Payment
Interest Rate Parity
Purchasing Power Parity

3

Introduction:
International Trade :
International trade is the exchange of goods and services between countries. This type of trade gives
rise to a world economy, in which prices, or supply and demand, affect and are affected by global
events. Political change in Asia, for example, could result in an increase in the cost of labor, thereby
increasing the manufacturing costs for an American sneaker company

International trade theory is based on the principle of comparative advantage which is in turn based
on the concept of opportunity cost.

Opportunity Cost:
Opportunity cost is the cost of any activity measured in terms of the value of the best alternative
that is not chosen (that is foregone).

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4

Production Possibility Frontier
A curve depicting all maximum output possibilities for two or more goods given a set of inputs
(resources, labor, etc.). The PPF assumes that all inputs are used efficiently.

5

Imp
Video Games
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Difference Between Domestic Trade And
International Trade
Domestic Trade International Trade
Domestic trade, also known as internal trade or home
trade, is the exchange of domestic goods within the
boundaries of a country. This may be sub-divided into
two categories, wholesale and retail.
International trade is the exchange of capital, goods
and services across international borders or
territories.
Domestic business pertains to a limited territory.
Though the firm has many business establishments
in different locations all the trading activities are
inside a single boundary.
Scope of international business is quite wide. It
includes not only merchandise exports, but also trade
in services, licensing and franchising as well as
foreign investments
Domestic business is conducted locally so there is
no involvement of foreign currency.
International business nations gain by way of earning
foreign exchange, more efficient use of domestic
resources,
The main difference is that international trade is
typically more costly than domestic trade
6

A trade bloc is a type of intergovernmental agreement, often part of a regional inter governmental
organization, where regional barriers to trade, (tariffs and non-tariff barriers) are reduced or eliminated
among the participating states.

Reduction in Trade restriction have positive effect result from increased trade according to
comparative advantage as well as increase in competition

The negative effect result because some firms, some industries, some group of worker will see their
wealth and income decrease. Worker in affected industries may need to learn new skills to get new
jobs.

7

Trade Bloc Motivation
Common Market Remove all barriers to the movement of labor and capital goods among members.
Economic Union Member countries establish common institutions and economic policy for the union.
Monetary Union Member countries also adopt a single currency
Customs Union Member countries adopt a common set of trade restriction with non-member
Free Trade Area All barrier to the import and export of goods and services among member countries
are removed
8

Comparative Advantage And Absolute Advantage
Absolute Advantage: A country is said to have an absolute advantage in the production of a good if it
can produce the good at lower cost in terms of resources than that of another country

Comparative Advantage: A country is said to have Comparative advantage in the production of a
good if its opportunity cost in terms of other goods that could be produced instead is lower than that of
another country

Even if a country does not have an absolute advantage in the production of any good, It can gain from
trade by producing and exporting the goods by which it has comparative advantage and importing
goods in which it has comparative disadvantage.

9

Comparative Advantage And Absolute Advantage
The law of comparative advantage says that two countries (or other kinds of parties, such as
individuals or firms there as) will both gain from trade if, in the absence of trade, they have different
relative costs for producing the same goods.

Even if one country is more efficient in the production of all goods (absolute advantage) than the
other, both countries will still gain by trading with each other, as long as they have different relative
efficiencies.

For example, if, using machinery, a worker in one country can produce both shoes and shirts at 6 per
hour, and a worker in a country with less machinery can produce either 2 shoes or 4 shirts in an hour,
each country can gain from trade because their internal trade-offs between shoes and shirts are
different.

The less-efficient country has a comparative advantage in shirts, so it finds it more efficient to produce
shirts and trade them to the more-efficient country for shoes.

10

Ricardian And Heckscher- Ohlin Models Of Trade And
Sources Of Comparative Advantage
The Ricardian model assumes that labor is the only primary input to production (labor is considered
to be the ultimate source of value)

The Ricardian model focuses on comparative advantage, perhaps the most important concept in
international trade theory.

In Ricardian model of trade, comparative advantage and pattern of trade are determined by difference
in technology between country. In H - O model of trade, comparative advantage and the pattern of
trade are determined by difference of factor endowment between countries .

In a Ricardian model, countries specialize in producing what they produce best, and trade occurs due
to technological differences between countries. Unlike other models, the Ricardian framework predicts
that countries will fully specialize instead of producing a broad array of goods.

The main advantage of Ricardian model is that it assumes technological differences between
countries. Technological gap is easily included in the Ricardian and Ricardo-Sraffa model.

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11

The Heckscher-ohlin Model (H-O Model) Makes
The Following Core Assumptions
Assumptions of H-O model:
Labor and capital flow freely between sectors
The amount of labor and capital in two countries differ (difference in endowments)
Free trade
Technology is the same among countries (a long-term assumption)
Taste and preferences are the same.
The problem with the H-O theory is that it excludes the trade of capital goods (including materials and
fuels). In the H-O theory, labor and capital are fixed entities endowed to each country. In a modern
economy, capital goods are traded internationally. Gains from trade of intermediate goods are
considerable, as emphasized by Samuelson .

12

Heckscher-ohlin Model And Its Assumption
In the early 1900s an international trade theory called factor proportions theory was developed by two
Swedish economists, Eli Heckscher and Bertil Ohlin. This theory is therefore called the Heckscher-
Ohlin theory (H-O theory).

The H-O theory stresses that countries should produce and export goods that require resources
(factors) that are abundant and import goods that require resources in short supply.

It differs from the theories of comparative advantage and absolute advantage since those theories
focus on the productivity of the production process for a particular good. On the contrary, the H- O
theory states that a country should specialize in producing and exporting products that use the factors
that are most abundant, and thus are the cheapest to produce.

The Heckscher-Ohlin model was produced as an alternative to the Ricardian model of basic
comparative advantage. Despite its greater complexity it did not prove much more accurate in its
predictions. However from a theoretical point of view it did provide an elegant method of incorporating
the neoclassical price mechanism into international trade theory.
13

Compare Type Of Trade And Capital Restrictions And
Their Economic Implication
A trade restriction is an artificial restriction on the trade of goods between two countries. It is the
result of protectionism. However, the term is not uncontroversial since what one part may see as a
trade restriction another may see as a way to protect consumers from inferior, harmful or dangerous
products.

There are many reason why government impose trade restriction. Some have support among
economist as conceivably valid in terms of increasing a countrys welfare, while other have little or no
support from economic theory.

Capital Restriction: It is defined as control placed on foreigners ability to own domestic assets and
domestic residents ability to own foreign assets. Thus , in control with trade restriction, which limit the
openness of goods market, capital restriction limit the openness of the financial market.
14

Compare Type Of Trade And Capital Restrictions And
Their Economic Implication (Cont..)
Capital Restriction are defined as control placed on foreigners ability to own domestic assets and
domestic residents ability to own foreign assets. In contrast to trade restriction, which limits to
openness of goods markets, capital restriction limit the openness of financial market.

Reasons of Trade Restriction :
Infant Industry
National Security
Protecting domestic jobs
Protecting domestic industries.

Type of Trade Restriction Include:
Tariffs
Quotas
Export subsidies
Minimum domestic content
Voluntary export restraint
15

Balance Of Payment Account
Balance of payment account (BOP) is the account of a country
It is record of transactions of residents of country with rest of world.
It records payments and receipts from rest of world
Any transaction giving rise to payment is deficit (negative) e.g. purchase of property in USA, imports
Any transaction giving rise to receipt is credit (positive) e.g. exports, gifts from outside

BOP equation must satisfy all the time, which is
Current A/c + Capital A/c + net reserves = 0

16

Accounts in BOP
Current account Records trade in goods and services, transfer
payments, profits and interests earned on assets
abroad less profits and interests earned by foreigners
on assets in our country
Capital account (financial
account)
Records transactions in financial assets and land e.g.
bond, stocks

Official settlement
account ( Net reserves)
Records changes in official reserves which are gold,
foreign currency
Explain How Decision By Consumers, Firms, And
Government Influence The Balance Of Payment (Cont.)
Low private saving and high investment trend to produce a current account deficit that must
be financed by net capital imports, high private saving and low investment, however produce a
current account surplus, balanced by net capital exports.

A govt. deficit produce a current account deficit and a govt. surplus lead to current account
surplus.

In equilibrium, we have the relationship :

Export- Import = Private Saving + Govt. Saving Domestic investment

Lower level of private saving, Larger govt. deficit , and high rate of domestic investment all
tend to result in or increase a current account deficit. When total saving is less than domestic
investment, export must be greater than import so that there is a deficit in the current account.

Low private or govt. saving in relation to private investment in domestic capital requires foreign
investment in domestic capital.
17

Functions And Objective Of International Organization That
Facilitate Trade, Including The World Bank, IMF, And WTO
The International Monetary Fund (IMF) is an organization of 187 countries, working to foster global
monetary cooperation, secure financial stability, facilitate international trade, promote high
employment and sustainable economic growth, and reduce poverty around the world

The organization's stated objectives are to promote international economic cooperation, international
trade, employment, and exchange rate stability, including by making resources available to member
countries to meet balance of payments needs.

The Main objectives of IMF:
- Assisting in the establishment of a multilateral system of payments
- Promoting international monetary corporation
- balanced growth of international trade
- Facilitating the expansion of the member countries
- Make resources available to members experiencing balance of payment difficulties.

18

Describe Functions And Objective Of International
Organization
The World Bank is an international financial institution that provides loans to developing
countries for capital programs. The World Bank's official goal is the reduction of poverty

The International Bank for Reconstruction and Development (IBRD) is one of five institutions that
compose the World Bank Group. The IBRD is an international organization whose original mission
was to finance the reconstruction of nations devastated by World War II. Now, its mission has
expanded to fight poverty by means of financing states. Its operation is maintained through payments
as regulated by member states.

The IBRD provides loans to governments, and public enterprises, always with a government (or
"sovereign") guarantee of repayment subject to general conditions. The funds for this lending come
primarily from the issuing of World Bank bonds on the global capital markets

19

Describe Functions And Objective Of International
Organization
World Trade Organization :
The World Trade Organization (WTO) is an organization that intends to supervise
and liberalize international trade.
The organization deals with regulation of trade between participating countries; it provides a
framework for negotiating and formalizing trade agreements, and a dispute resolution process aimed
at enforcing participants' adherence to WTO agreements which are signed by representatives of
member governments and ratified by their parliaments.

Functions of World Trade Organization :
Among the various functions of the WTO, these are regarded by analysts as the most important:

It oversees the implementation, administration and operation of the covered agreements.
It provides a forum for negotiations and for settling disputes.
Additionally, it is the WTO's duty to review and propagate the national trade policies, and to ensure
the coherence and transparency of trade policies through surveillance in global economic policy-
making.
Another priority of the WTO is the assistance of developing, least-developed and low-income
countries in transition to adjust to WTO rules and disciplines through technical cooperation and
training

20

Practice - Questions
Q.1 Which among the following most likely contribute to current account deficit?
a) High Taxes
b) Low private Saving
c) Low Private Investment

Q. 2 Which of the following factor best explain why regional trading agreement are more popular than larger
multilateral trade agreement?
a) Minimal displacement cost
b) Trade diversion benefit members
c) Quicker and easier policy coordination

Q. 3 Patent fees, Legal services are recorded in which of the following balance of Payment componenet?
a) Capital account
b) Current account
c) Financial account
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Q. 4 In Ricardian trade model, comparative advantage is determined by :
a) Technology
b) The Capital to labor Ratio
c) The level of labor productivity

Q. 5 According to the Hecksher- Ohlin mode, when trade opens:
a) The scare factor gains relative to the abundant factor in each country
b) The abundant factor gains relative to the scare factor in each country
c) Income is redistributed between countries but not within each country

Q. 6 Which of the following is the best describe the benefit of international trade?
a) Countries gain from exchange and specialization
b) Countries receive lower price for their exprots and pay higer prices for improt
c) Absolute advantage is required for a country to benefit from trade in the long term
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Solutions:
1. B
2. C
3. B
4. A
5. B
6. A

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Agenda
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International Trade and Capital Flows
Currency Exchange Rates

Exchange Rates
Two types of exchange rates
Nominal exchange rate (FX)
Real exchange rate

Nominal exchange rate (FX)
Amount of currency that is required to buy one unit of other currency
Price of one currency in terms of another
Example, Assume nominal exchange rate between Indian rupee and US dollar is 45 Rs per $ (Rs/$)
i.e. to purchase 1 $ we need Rs 45
Exchange rate can be expressed any way i.e. either Rs/$ or $/Rs
Numerator currency expresses the price of one unit of denominator currency

Real Exchange Rate:

25

(
=
Domestic
Foreign
CPI
CPI
rate(d/f) exchange Nominal Rate(d/f) Exchange Real
Real Exchange Rate
Real exchange rate:
Focus shifts to purchasing power of currency
Quantity of real goods an services that currencies can actually purchase
Real exchange rate (REER) = Nominal exchange rate * ( Price in country A / Price in country B )
Where, Nominal exchange rate = Currency of country B / Currency of country A
It is the ratio of foreign to domestic prices measured in the same currency
Rise in REER (depreciation of domestic currency) implies that foreign goods have become expensive
than domestic goods
REER = 1 implies that a good costs same in both countries taking nominal exchange rate in account
Let, Nominal exchange rate (FX) = 45 Rs/$, Price of shirt in USA = 15$, Price of shirt in India = Rs 500
REER = 45 * (15 / 500) = 45 * ( 3/100) = 135/100 = 1.35
It costs 35% more to purchase same shirt in USA than in India
It requires $1.35 to purchase a good in USA that can be purchased for 1$ (in Indian rupees) in India at
current nominal exchange rate

26

Foreign Exchange Market
Measured by average daily turnover, the foreign exchange market is the largest financial market in the
world.
There is wide diversity of global FX market participants that have a wide variety of motives for
entering into foreign exchange transaction.
Individual currencies are usually referred to by standardize three character code. These currency
code can also be used to define exchange rate.
Currencies trade in the foreign exchange market based on nominal exchange rates

Participants in the foreign exchange market :
Investment management firms
Non-bank foreign exchange companies
Foreign exchange fixing
Central banks
Retail foreign exchange traders
Hedge funds as speculators
Money transfer/remittance companies
Commercial companies

27

Imp
Spot And Forward Markets For Foreign Exchange
Spot FX markets
It is the currency exchange rate for immediate delivery, which for most currencies means the exchange of
currency takes place two days after the trade.
Transactions that had to be settled immediately like trading of equity
Settlement period is two business days after trade

Forward FX markets
Transactions that will be settled in future
Exchange of currencies takes place in future at the exchange rate agreed today
Forward contracts are generally for 30,60,90 and 180 days
Allows the firm to hedge against exchange rate uncertainty or fluctuations
Forward rate can be greater or less than spot exchange rate
Forward exchange rate represents the interest differential between two countries
28

Foreign Exchange
Appreciation of currency
When it requires less of domestic currency to purchase 1 unit of foreign currency
Example, FX decreasing from 46 Rs/$ to 40 Rs/$
Reduces the demand of domestic currency
Increases supply of domestic currency
Increases imports as foreign products become cheaper in international market
Domestic consumers demand more of foreign products

Depreciation of currency
When it requires more of domestic currency to purchase 1 unit of foreign currency
Example, FX increasing from 46 Rs/$ to 50 Rs/$
It raises the demand of domestic currency
Decreases supply of domestic currency
Increases exports as domestic products become cheaper in international market
Foreigners demand more of domestic currency

29

Exchange Rate Quotes
Two kind of quotes

Direct quote
A foreign exchange rate quoted as the domestic currency per unit of the foreign currency. In other words,
it involves quoting in fixed units of foreign currency against variable amounts of the domestic currency.

Price of one unit of foreign currency in terms of domestic currency
Exchange rate of 46 Rs/$ is a direct quote for Indian citizen
It tells the value of 1 unit of foreign currency in terms of domestic currency to domestic resident
Value of foreign currency is fixed at 1 and value of domestic currency is variable
Domestic currency per unit of foreign currency

For example, in the U.S., a direct quote for the Canadian dollar would be US$0.85 = C$1. Conversely,
in Canada, a direct quote for U.S. dollars would be C$1.17 = US$1.

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Exchange Rate Quotes
Indirect quote

A foreign exchange rate quoted as the foreign currency per unit of the domestic currency. In an indirect
quote, the foreign currency is a variable amount and the domestic currency is fixed at one unit.

Price of one unit of domestic currency in terms of foreign currency
Exchange rate of 46 Rs/$ is a indirect quote for US citizen
It tells the value of 1 unit of domestic currency in terms of foreign currency to domestic resident
Value of domestic currency is fixed at 1 and value of foreign currency is variable
Foreign currency per unit of domestic currency

For example, in the U.S., an indirect quote for the Canadian dollar would be C$1.17 = US$1.
Conversely, in Canada an indirect quote for U.S. dollars would be US$0.85 = C$1

To convert an indirect quote to direct quote
Take the reciprocal of exchange rate
Example Indirect quote 46 Rs/$ for US citizen
Direct quote 1/46 $/Rs = 0.0217 $/Rs for US citizen

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The Percentage Change In A Currency Relative
To Another Currency
For a change in an exchange rate, we can calculate the percentage appreciation (price goes down) or
depreciation (price goes up) as the percentage change in the price currency.

For example, a decrease in the USD/ EUR exchange rate from 1.44 to 1.42 represents an
appreciation of the USD relative to the EUR of 1.39% (1.42 / 1.44 1 = - .0139)

To calculate the appreciation or depreciation of the base currency, we first invert the quotes and then
proceed as the above example.

32

Currency Cross Rates
Cross rates
Exchange rates between two currencies derived from exchange rate with a common third currency
Example, let Rs/$ = 46 and $/GBP = 1.67
then Rs/GBP = ( Rs/$ ) * ( $/GBP) = 46 * 1.67 = 76.82
Hence, Rupee - Pound cross rate is 76.82 Rs/GBP
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Forward Discount And Premium
A forward premium or discount is calculated

Forward discount
Assume INR/$
If forward price of INR/$ is greater than spot price of INR/$
Then, INR is quoted as forward discount
INR (domestic currency) is cheaper today than future

Forward premium
Assume INR
If forward price of INR/$ is lesser than spot price of INR/$
Then, INR is quoted as forward premium
INR (domestic currency) is expensive today than future

34

Forward Discount And Premium
Annualized forward percentage premium/discount (AF)

If one currency is in premium then other is in discount
Use mid points of bid ask to calculate annualized forward premium/discount if bid ask spot and
forward quotes are given in exam

35

n Rate Spot
Rate Spot Rate Forward
AF
n
360
*
=
Interest Rate Parity
Interest rate parity
Expected returns on deposit of two currencies should be equal when measured in same currency
Forward premiums and discounts wipe out the differences in interest rates between two countries
If interest rates are higher in country A compared to country B, then currency of country A will depreciate
thus equating returns in both countries
Mathematically,

where F = forward rate; S = Spot rate; R = risk free interest in both countries

Forward and spot quotes are direct quotes to investor of country A i.e. B : A
Alternate mathematical representation

When interest rate parity holds
Higher (lower) nominal interest rate in country will lead to currency selling at forward discount (premium)
Simply put, IRP implies that interest rate differentials is equal to forward rate differential.

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B
A
R
R
S
F
+
+
=
1
1
B
B A
R
R R
S
S F
+
1
Same good should cost equal in different countries considering the nominal exchange rate
REER should be equal to 1

Example, FX = 45 Rs/$, Price of shirt in USA = $15
then, in India Price of shirt should be = 15 * 45 = Rs 675
But the shirt in India is for Rs 500
This is due to many factors like taxes, subsidies, transportation costs etc
Nominal exchange rate (FX) should change such that REER becomes equal to 1
Therefore, FX * (15/500) = 1
FX = 500/15 = 33.33 Rs/$

37

Exchange Rate Regimes
Each country, through varying mechanisms, manages the value of its currency. As part of this
function, it determines the exchange rate regime that will apply to its currency. For example, the
currency may be free-floating, pegged or fixed, or a hybrid.

If a currency is free-floating, its exchange rate is allowed to vary against that of other currencies and is
determined by the market forces of supply and demand. Exchange rates for such currencies are likely
to change almost constantly as quoted on financial markets, mainly by banks, around the world.

A movable or adjustable peg system is a system of fixed exchange rates, but with a provision for the
devaluation of a currency. For example, between 1994 and 2005, the Chinese yuan renminbi (RMB)
was pegged to the United States dollar at RMB 8.2768 to $1.

38

Exchange Rate Policies
Three common strategies:

Flexible exchange rate
Exchange rate is freely determined by market through demand and supply

Fixed exchange rate
Government or central bank fixes exchange rate at some level
It undertakes policies or intervene in market such that demand and supply side can be managed to maintain
the exchange rate at fixed level
Prevents volatility in exchange rate
Decreases exchange rate risks

Crawling exchange rate policy
Government or central bank sets a band, having lower and upper limit, within which exchange rate can
fluctuate
It undertake policies or intervene in market to keep the exchange rate within the band
Band is revised periodically
Decreases exchange rate risks

39

Impact Of Exchange Rate On Countries International
Trade And Capital Flows.
Elasticity of export and import demand must meet the Marshall-Lener condition for a depreciation of
the domestic currency to reduce an existing trade deficit.

Export - Import = (Private Saving - Investment in physical capital) + (Tax revenue - Govt. Spending)

The J curve :
Import and Export quantities may be relatively insensitive to currency depreciation in the short run.
Currency depreciation may worsen a trade deficit.
The short term increase in the deficit followed by a decrease when the Marshall- Lerner condition is
met is referred to as the J- curve.

Under the absorption approach, national income must increase
relative to national expenditure in order to decrease a trade deficit.
This can also be viewed as a requirement that national saving must
increase relative to domestic investment in order to decrease a trade deficit.

40

E
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1. Assuming annual interest rate is 8% in India and 1.5% in USA. Let spot exchange rate is 47.10 Rs
per $. What is the forward rate.
a. For 3 months
b. For 6 months
c. For 1 year
d. Let the forward rate in market for 1 year is 48 Rs per $. Is there any opportunity for arbitrage.

2. Assuming the 180 days forward rate for GBP:USD is 1.65 and the spot rate is GBP:USD is 1.60. Is
USD trading at forward premium or forward discount to GBP. Calculate the annualized premium or
discount and whether the USD is strong or weak.

3. Let the exchange rate for USD and GBP is 1.65$ per GBP and forward rate is 1.60 $ per GBP.
Assuming Interest rate parity holds then in which country will be the interest rate higher.

4. The bid ask quote for GBP in India is 78.20 78.50 (GBP:INR) . In New York the bid ask quote for
Indian Rupee is 46 46.30 (USD:INR). What is the USD: GBP ask as a cross rate.

41

5. The following quotes are available at GNB
USD:INR = 45.13
GBP:USD = 1.5424
GBP:INR = 70.02
Compute any arbitrage opportunity that may be available in the above case. Calculate the arbitrage
profit from $1,000.

6. Given the $:won rates of 1,146.25 1,148.35
One year interest rate $ = 4.2 4.8%
One year interest rate won = 2.3 2.7%
Calculate the one year forward rate for $:won and also specify which of the two is the stronger
currency.
A. 1,200-1,210 , won is stronger
B. 1,200-1,210, dollar is stronger
C. 1,200-1,210, dollar is stronger
42

Practice Question
7 A shirt costs 15 $ in USA and 9 GBP in Great Britain. Assuming the exchange rate of 1.6 $ per GBP.
In which country is the shirt more expensive?

8 Let the interest rates in USA are 2% higher than the interest rates in Great Britain and the exchange
rate is 1.6 $ per GBP. Assuming that the interest rate parity holds, then what will be the expected
future exchange rate.

43

Practice - Solutions
1. a. For 3 months
F
3-months
= S*(1.08/1.015)
0.25
= 47.84
b. For 6 months
F
6-months
= S*(1.08/1.015)
0.5
= 48.58
c. For 1 year
F
12-months
= S*(1.08/1.015)

= 50.12
d. Let the forward rate in market for 1 year is 48 Rs per $. Yes there any arbitrage opportunity

2. Since the forward rate is trading at $1.65/GBP therefore the USD is trading at a forward discount to
the GBP. The annualized discount is 6.25%. Since the USD is trading at a forward discount it is the
weaker currency in the exchange pair.

3. Since the USD is trading at a premium to the GBP in the forward market. The GBP risk-free rate is
greater than the USD risk-free rate

4. Given the bid-ask rates the USD:GBP cross rates are (USD:GBP)
ask
= 78.2/46.3 = 1.6890
(USD:GBP)
bid
= 78.5/46 = 1.7065
44

5. The following quotes are available at GNB
USD:INR = 45.13
GBP:USD = 1.5424
GBP:INR = 70.02
Compute any arbitrage opportunity that may be available in the above case. Calculate the arbitrage
profit from $1,000
The cross rate for GBP:INR = 45.13*1.5424 = 69.61. Since the GBP:INR rate provided by GNB is
higher a triangular arbitrage is possible. Given 1,000 USD. A triangular arbitrage is possible through
the following series of transactions
a. Convert USD to GBP
1,000 USD /1.5424 = 648.34 GBP
b. Convert GBP to INR
648.34 * 70.02 = 45,396.78 INR
c. Convert INR to USD
45,396.78/45.13 = 1,005.9 USD

Thus a profit of 5.9 USD is possible through a triangular arbitrage.
45

6.

The forward is selling at a discount to the spot therefore the won is the weaker currency.

46

82 . 131 , 1
042 . 1
027 . 1
* 35 . 148 , 1
($)
) ( * ) : ($
) : ($ = = =
bid
ask ask
ask
r
won r won S
won F
91 . 118 , 1
048 . 1
023 . 1
* 25 . 146 , 1
($)
) ( * ) : ($
) : ($ = = =
ask
bid bid
bid
r
won r won S
won F
Practice Solutions
7. The cost of the shirt in Great Britain in USD = 9*1.6 = 14.4 USD
The shirt is cheaper in Great Britain than in the USA

8 Through Interest Rate Parity

Therefore E(S) = S*(1.02) = 1.6*1.02 = 1.632

47

i u
R
S
S S E
R =
+
) (
Five Minute Recap
48

Production Possibility Frontier

V
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d
e
o

g
a
m
e
s

(
u
n
i
t
s
)

6
3
40 50
10
3
A
B
Books(Units)
Annualized forward percentage
premium/discount (AF):

n Rate Spot
Rate Spot Rate Forward
AF
n
360
*
=
Common strategies Exchange
Rate Policies:
Flexible exchange rate
Fixed exchange rate
Crawling exchange rate policy
Export - Import = (Private Saving- Investment in physical capital) + (Tax revenue - Govt. Spending)
Forward and spot quotes

B
B A
R
R R
S
S F
+
1
B
A
R
R
S
F
+
+
=
1
1
Interest Rate Parity:

Terms to Remember:
Appreciation of currency
Depreciation of currency
Currency Cross Rates
Spot FX Markets
Forward FX Markets
Law of Comparative Advantage
Trade Restriction
Capital Restriction

Balance Of Payments:
Current A/c + Capital A/c + Net Reserves = 0
(
=
Domestic
Foreign
CPI
CPI
rate(d/f) exchange Nominal
Real Exchange Rate:

E
c
o
n
o
m
i
c

W
e
l
f
a
r
e

Time
J Curve

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